Kingdom of Jordan celebrates a decade of fixed exchange rates and economic stability

Commentary by Henry T.azzam

In October 1995, the Central Bank of Jordan took a strategic decision to peg the Jordanian dinar (JD) to the dollar at the fixed exchange rate of $1.41 to the dinar. This has served the Jordanian economy quite well, reducing inflationary pressures and maintaining the purchasing power of consumers.

For the past 10 years, exchange-rate stability prevailed and no major events of speculative pressure on the dinar was recorded.

The fixed JD/dollar peg has greatly mitigated any residual risk of devaluation that was still on the minds of savers and investors. It provided a credible anchor for noninflationary monetary policy and made it possible for the Central Bank to steer interest rates on the Jordanian dinar to levels much lower than would have been possible otherwise. The fact that the country's foreign reserves have reached today an all time high of $5.1 billion attest to the success of the fixed exchange rate strategy. It also reflects the successive surpluses recorded by the country's balance of payments.

Countries following floating exchange rates have the option of devaluing their currencies to make imports more expensive in the local market and exports cheaper i.e. more price competitive in the international markets. Such advantages do not necessarily hold for Jordan. The kingdom's major exports are phosphate, potash, chemicals and pharmaceutical products. These are priced in dollars and a weaker JD/dollar exchange rate will not add to their price competitiveness in the export markets. As for imports, exchange rate uncertainty associated with the floatation of the currency is more disruptive to importers than higher import prices.

The exchange-rate regime of a country should take into account all aspects of that country's balance of payment i.e. its balance of trade, its balance of services and the capital account balance. In Jordan, the historically large deficits in the balance of trade are usually offset by surpluses in the balance of services.

The huge deficit in Jordan's trade balance sustained in 2004 and the first half of 2005 was mainly due to the surge in the country's oil-import bill which accounts for 25 percent of all imports. Oil is priced in dollars and the demand for gasoline and other fuels is inelastic i.e. not responsive to higher prices. A weaker JD/dollar exchange rate therefore would have no impact on a large part of the import bill.

Equally important is the fact that Jordan has a liberalized capital account regime with no restrictions on capital inflows and outflows. It is these capital movements in and out of the country that will be mostly affected if an exchange risk element is introduced as it is the case with floating rates. This is where the main advantage of a fixed JD/dollar exchange rate lies. It maintains investors confidence in the currency and reduces exchange rate risk, thus encouraging domestic saving and investments in the JD and discouraging capital outflows.

Some could argue that the JD is overvalued at the current level of JD/dollar exchange rate, and a lower peg is needed. For any discussion of the "fair" value of a currency, that value first has to be defined. The oldest theory for doing this is the purchasing power parity, which says that is the long run, the exchange rates of two currencies should equalize the prices of a tradable basket of goods and services in the two countries. The Big Mac index was devised by The Economist magazine in 1986 as a crude indicator of whether currencies are at their fair exchange rate value. The basket in this case is limited to the Big Mac hamburger claimed by McDonald's to be roughly the same in all the company's outlets world wide.

A Big Mac in Jordan costs JD1.85 ($2.61 at the fixed exchange rate of $1.41 to the JD) compared to an average price of $3.06 in the U.S. This suggests that the dinar is 15 percent undervalued against the dollar, i.e. it is 15 percent below the exchange rate needed to equalize the burger's price in the two countries. However, not all inputs in the Big Mac are tradable. Labor, rent on the retail space, taxes and electricity account for more than half the price of a Big Mac. This means that if the JD is under valued against the dollar, the ratio would not exceed 7 percent.

The last 10 years have proven that the advantages of having a fixed JD/dollar exchange rate far outweigh the disadvantages. We have learned from this experience that a fixed exchange regime provides a credible anchor for monetary policy. It is like putting the economy in a straight jacket which does not allow any excesses. If governments overspend and deficits are financed through borrowing from the Central Bank or by arbitrary printing of the currency, the jacket becomes tight and cracks start to appear.

The budget deficit is expected to reach a record high of JD 722 million by the end of 2005 due mainly to the huge increase of world oil prices. This is almost 8.8 percent of GDP, compared to the original estimate for this year of 3.3 percent. The situation could have been worse if the economy has not been growing at the annual real rate of 7.7 percent. Inflation has also edged higher at 5.7 percent in the past 12 months, while the country's trade deficit in the first half of the year is 50 percent higher compared to the same period of 2004. Strong remedial measures will have to be taken, putting the economy on a strict diet of fiscal discipline.

It is comforting to see the Central Bank of Jordan has started raising interest rates on the dinar to levels higher than those on the dollar. Rates on five-year government bonds have reached 9 percent recently. However, tighter monetary policy is necessary to tackle the current imbalances but is not sufficient on its own. A more balanced budget should be implemented in 2006, with lower current expenditures, higher public revenues, and more privatization deals. This will solidify macroeconomic stability and send a clear and loud message to speculators that the dinar will not be floated on the dollar; not now, and not any time in the foreseeable future.